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The Effect of Exchange Rate Volatility on Economic Growth

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The Effect of Exchange Rate Volatility on Economic Growth Journal of Risk and Financial Management Article The Effect of Exchange Rate Volatility on Economic Growth: Case of the CEE Countries Fatbardha Morina 1 , Eglantina Hysa 2 , U˘gurErgün 1, Mirela Panait 3 and Marian Catalin Voica 3,* 1 Department of Banking and Finance, Epoka University, 1032 Tirana, Albania; [email protected] (F.M.); [email protected] (U.E.) 2 Department of Economics, Epoka University, 1032 Tirana, Albania; [email protected] 3 Department of Cybernetics, Economic Informatics, Finance and Accounting, Petroleum-Gas University of Ploiesti, 100680 Ploiesti, Romania; [email protected] * Correspondence: [email protected]; Tel.: +40-722-464-948 Received: 20 July 2020; Accepted: 7 August 2020; Published: 10 August 2020 Abstract: The exchange rate is a key macroeconomic factor that affects international trade and the real economy of each country. The development of international trade creates conditions where volatility comes with the exchange rate. The purpose of this paper is to examine the effect of real effective exchange rate volatility on economic growth in the Central and Eastern European countries. Additionally, the effect, through three channels of influence on economic growth which vary on the measurement of exchange rate volatility, is examined. The study uses annual data for fourteen CEE countries for the period 2002–2018 to examine the nature and extends the impact of such movements on growth. The empirical findings using the fixed effects estimation for panel data reveal that the volatility of the exchange rate has a significant negative effect on real economic growth. The results appear robust with alternative measures of exchange rate volatility such as standard deviation and z-score. This paper suggests that policymakers should adopt different policies to keep the exchange rate stable in order to foster economic growth. Keywords: real effective exchange rate; volatility; economic growth; CEE countries 1. Introduction After the failure of the Bretton Woods system in 1970, the regime of the exchange rate changed across countries. From this time there has been an increase in the usage of floating exchange rates, but rather most countries have adopted flexible intermediate regimes including conventional pegs. Also, many countries do not allow their nominal exchange rate to move freely since they feel the fear of floating as Levy-Yeyati and Sturzenegger(2005). Thus, in countries where the fixed exchange rate is adopted, it is the responsibility of the central bank of the world’s major economies to maintain the exchange rate, fixed by buying and selling currencies in order to correct the demand and supply of the money in the market. The proponents of the exchange rate regime argue that this process of maintaining fixed exchange rate regimes is difficult but keeping a stable exchange rate along with macroeconomic stability boost international trade and investment that in turn enhance growth. In 1973, floating exchange rates in Europe made nominal and real interest rates more volatile, which discourages investment due to the risk that comes with the exchange rate. The transaction cost of international trade has become more expensive and reduces the gains of investors as it constrains their decisions to develop their activity. The economists believed that floating rates may be harmful to the economy because every country uses the currency as an intermediate to purchase products and services in international trade. When the exchange rate becomes volatile, they are faced with uncertainty regarding the agreement J. Risk Financial Manag. 2020, 13, 177; doi:10.3390/jrfm13080177 www.mdpi.com/journal/jrfm J. Risk Financial Manag. 2020, 13, 177 2 of 13 with other countries. The concern related to exchange rate risk is not only for policymakers but also for academics. The risk or the uncertainty regarding the unpredictable changes over time on the exchange rate can be defined as volatility. Shocks are the main source of unpredictable changes that can affect the price of goods, inflation, interest rates, portfolio investment, savings and loans (Clarida and Gali 1994). Interest rate has become a referential to financial markets and it is a reflection of competitiveness (Bostan and Firtescu 2019). The international financial crisis, the increased pace of contagion, the liberalization of capital movements, and expansion of globalization imposed new dimensions for the importance of the interest rate. A consideration of the empirical studies has shown the effect of the fluctuation of exchange rates on exports, trade, investment, capital market, inflation, and employment growth—in developing and developed countries (Schnabl 2008; Jamil et al. 2012; Rjoub 2012; Allen et al. 2016; Alagidede and Ibrahim 2017; Dal Bianco and Loan 2017; Latief and Lefen 2018; Vo and Zhang 2019; Hatmanu et al. 2020; Ioan et al. 2020). However, the effect of exchange rate volatility on economic growth for CEE countries has been studied by few authors and there has been a lack of studies over recent years—(Ricardo et al. 2007; Arratibel et al. 2011). The paper aims to examine not only the effect of real effective exchange rate volatility on economic growth for Central and Eastern European countries but also to investigate the impact of volatility through three different channels on economic growth and give information for policy makers. Different from previous studies, a comprehensive analysis of the nexus between exchange rate volatility and economic growth using different measures of volatility is employed to provide the robustness of the results. Using the Fixed effects model for annual data spanning 2002 to 2018 it was revealed that low volatility encourages economic performance. Also, the impact of macroeconomic factors such as government expenditure, gross fixed capital formation, inflation, trade openness was investigated. Trade openness and gross fixed capital formation enhance economic growth. Thus, the contribution of the current paper to exchange rate volatility and economic growth literature on CEE countries is three-fold. First, this paper attempts to fill the gap in the empirical literature related to the impact of exchange rate volatility on economic growth in CEE countries by using various measurements of volatility. The investigation of the impact of volatility on the growth of CEE countries is interesting since CEE countries are ex-communist countries with unique historical and economic experience that have a huge capacity to enhance national income by keeping stable exchange rates. Second, it examines three channels of influence where exchange rate volatility affects economic growth that differ from previous studies. Third, the study suggests policies that improve the linkage between the exchange rate fluctuation and growth. The remaining part of this study is structured as follows. Section2 presents the empirical literature regarding the influence of exchange rate volatility on trade, investment, and the real economy. Section3 outlines the methodology and description of the data. In Section4, the empirical results are given and discussed and Section5 draws the conclusions of this research paper. 2. Literature Review Theoretical literature on exchange rate volatility nexus economic growth is still a big debate among economists. The study by Obstfeld and Rogoff (1998) at the theoretical level posit that uncertainty on exchange rates and monetary policies followed by the government reducing the nominal interest rate and in turn causing an appreciation of the home currency can be deleterious for the home economy. In contrast, Devereux and Engel(2003) state that the e ffect of exchange rate volatility on the welfare of the economy depends on how prices are set. The fluctuation of macroeconomic factors and the dynamic nature of the business environment cause exchange rate volatility. The appreciation of currency happens by an upward movement while a downward movement indicates a loss in value (depreciation) against foreign currency (Anyanwu et al. 2017). Theories that explain this up and down movement in the exchange rate are the real option theory, the interest rate parity theory, purchasing power parity, traditional flow theory etc. According to the real option theory investment decisions are J. Risk Financial Manag. 2020, 13, 177 3 of 13 tightly connected with the effect of macroeconomic uncertainty (Dixit et al. 1994). Thus, the exchange rate volatility as an indicator of uncertainty explains the behavior of investor decisions. Stable exchange rates become more attractive for firms that decide to increase their investment. Therefore, the real option theory is used to examine the nexus between exchange rate volatility and economic growth by researchers. The empirical literature regarding the effect of exchange rate volatility on economic growth is unsettled and reviewing literature concern on channels where the exchange rate volatility affects the real economy is crucial. As it is mentioned by Schnabl(2008), the three channels where exchange rate volatility can enhance economic growth are international trade, foreign direct investment, and macroeconomic stability. Hooper and Kohlhagen(1978) examined the e ffect of exchange rate unpredictability on price and international trade between the United States and Germany. The study was conducted in the period 1965–1975 and they found that uncertainty regarding exchange rates has an adverse impact on trade but a positive impact on the price of products where the exporter is a risk-lover. Inconsistent negative effect on market price was found in the case of importers where uncertainty is measured as the standard deviation of spot and forward exchange rates over three months. Bahmani-Oskooee and Gelan(2018), employed the Autoregressive Distributed Lag (ARDL) model in their study in order to investigate the effects of exchange rate risk on trade flows in the short-run and long-run for twelve African countries during the period 1971Q1–2015Q4. The ARDL method has advantages in forcasting compared to other techniques based on co-integration. The volatility of the exchange rate improves or worsens exports and imports, but in the short run, the effect is more prevalent (Senadza and Diaba 2018).
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